Principles of managerial finance

CHAPTERS IN THIS PART1 The Role and Environment of Managerial Finance 2 Financial Statements and Analysis 3 Cash Flow and Financial Planning Integrative Case I: Track Software, Inc... Ma

CHAPTERS IN THIS PART

1 The Role and Environment of Managerial Finance

2 Financial Statements and Analysis

3 Cash Flow and Financial Planning

Integrative Case I: Track Software, Inc.

Across the Disciplines W H Y T H I S C H A P T E R M AT T E R S TO YO U

Accounting: You need to understand the relationships

between the firm’s accounting and finance functions; how the

financial statements you prepare will be used for making

investment and financing decisions; ethical behavior by those

responsible for a firm’s funds; what agency costs are and why

the firm must bear them; and how to calculate the tax effects of

proposed transactions.

Information systems: You need to understand the organization

of the firm; why finance personnel require both historical and

projected data to support investment and financing decisions;

and what data are necessary for determining the firm’s tax

liability.

Management: You need to understand the legal forms of

busi-ness organization; the tasks that will be performed by finance

personnel; the goal of the firm; the issue of management pensation; the role of ethics in the firm; the agency problem; and the firm’s relationship to various financial institutions and markets.

com-Marketing: You need to understand how the activities you sue will be affected by the finance function, such as the firm’s cash and credit management policies; the role of ethics in pro- moting a sound corporate image; and the role the financial mar- kets play in the firm’s ability to raise capital for new projects.

pur-Operations: You need to understand the organization of the firm and of the finance function in particular; why maximizing profit is not the main goal of the firm; the role of financial insti- tutions and markets in providing funds for the firm’s production capacity; and the agency problem and the role of ethics.

Explain why wealth maximization, rather thanprofit maximization, is the firm’s goal and how theagency issue is related to it

Understand the relationship between financialinstitutions and markets, and the role and opera-tions of the money and capital markets

Discuss the fundamentals of business taxation ofordinary income and capital gains, and explainthe treatment of tax losses

LG6 LG5

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Define finance, the major areas of finance

and the career opportunities available in this

field, and the legal forms of business

organization

Describe the managerial finance function

and its relationship to economics and

accounting

Identify the primary activities of the financial

manager within the firm

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LG2

LG1

1

Sometimes it seems that there’s a Starbucks

on every corner—and now in

supermar-kets and hospitals, too The company that

rev-olutionized the way we think about coffee now

has over 4,800 retail locations worldwide and

15 million customers lining up for lattes and

other concoctions each week

The chain’s success is tied to somewhat

unusual business strategies Its mission statement emphasizes creating a better work

environ-ment for employees first, then satisfying customers and promoting good corporate citizenship

within its communities For example, Starbucks was one of the first companies to offer part-time

employees health benefits and equity (ownership) The goal is to create an experience that builds

trust with the customer Profits are among the last of the company’s guiding principles

Starbucks’ bond with employees and customers has translated into sales and earnings as

strong as its coffee Annual sales growth from 1997 to 2000 ranged from 28 to almost 40 percent,

and annual growth in earnings per share ranged from about 12 to 81 percent A share of

Star-bucks’ stock purchased in November 1996 increased in value by 17 percent over the five years

ended November 2001 That compares favorably with the 15 percent gain realized by its industry

peers and the 7 percent gain for companies in the Standard & Poor’s 500 Index

Despite the U.S economic slowdown in 2001, the company expects to keep its growth

perk-ing over the next five years Although some fear that Starbucks has saturated the domestic

mar-ket, same-store sales keep rising as the company introduces new products Starbucks has even

become quite successful in unexpected markets, such as Japan

Accomplishing its business objectives while building shareholder value requires sound

financial management—raising funds to open new stores and build more roasting plants,

decid-ing when and where to put them, managdecid-ing cash collections, reducdecid-ing purchasdecid-ing costs, and

dealing with fluctuations in the value of foreign currency and with other risks as it buys coffee

beans and expands overseas To finance its growth, Starbucks went public (sold common stock)

in 1992, and its stock trades on the Nasdaq national market Its next securities offering was the

sale of convertible bonds, debt securities that could be converted into common stock at a

speci-fied price Those bonds were successfully converted into common stock by 1996, and today the

company has almost no long-term debt

Like Starbucks, every company must deal with many different issues to keep its financial

condition solid Chapter 1 introduces managerial finance and its key role in helping an

organiza-tion meet its financial and business objectives

4 PART 1 Introduction to Managerial Finance

finance

The art and science of managing

money.

financial services

The part of finance concerned

with the design and delivery of

advice and financial products to

individuals, business, and

government.

managerial finance

Concerns the duties of the

finan-cial manager in the business

firm.

financial manager

Actively manages the financial

affairs of any type of business,

whether financial or

nonfinan-cial, private or public, large or

small, profit-seeking or

not-for-profit.

W WW

The field of finance is broad and dynamic It directly affects the lives of every son and every organization There are many areas and career opportunities in thefield of finance Basic principles of finance, such as those you will learn in thistextbook, can be universally applied in business organizations of different types

per-What Is Finance?

Finance can be defined as the art and science of managing money Virtually all

individuals and organizations earn or raise money and spend or invest money.Finance is concerned with the process, institutions, markets, and instrumentsinvolved in the transfer of money among individuals, businesses, and govern-ments Most adults will benefit from an understanding of finance, which willenable them to make better personal financial decisions Those who work infinancial jobs will benefit by being able to interface effectively with the firm’sfinancial personnel, processes, and procedures

Major Areas and Opportunities in Finance

The major areas of finance can be summarized by reviewing the career nities in finance These opportunities can, for convenience, be divided into twobroad parts: financial services and managerial finance

opportu-Financial Services

Financial services is the area of finance concerned with the design and delivery of

advice and financial products to individuals, business, and government Itinvolves a variety of interesting career opportunities within the areas of bankingand related institutions, personal financial planning, investments, real estate, andinsurance Career opportunities available in each of these areas are described atthis textbook’s Web site at www.aw.com/gitman

Managerial Finance

Managerial finance is concerned with the duties of the financial manager in the

business firm Financial managers actively manage the financial affairs of any

type of businesses—financial and nonfinancial, private and public, large andsmall, profit-seeking and not-for-profit They perform such varied financial tasks

as planning, extending credit to customers, evaluating proposed large tures, and raising money to fund the firm’s operations In recent years, the chang-ing economic and regulatory environments have increased the importance andcomplexity of the financial manager’s duties As a result, many top executiveshave come from the finance area

expendi-Another important recent trend has been the globalization of business ity U.S corporations have dramatically increased their sales, purchases, invest-ments, and fund raising in other countries, and foreign corporations have likewise

activ-CHAPTER 1 The Role and Environment of Managerial Finance 5

sole proprietorship

A business owned by one person

and operated for his or her own

profit.

unlimited liability

The condition of a sole

propri-etorship (or general partnership)

allowing the owner’s total

wealth to be taken to satisfy

creditors.

partnership

A business owned by two or

more people and operated for

profit.

corporation

An artificial being created by

law (often called a “legal

entity”).

articles of partnership

The written contract used to

formally establish a business

partnership.

Hint For many small

corporations, as well as small

proprietorships and

partner-ships, there is no access to

financial markets In addition,

whenever the owners take out a

loan, they usually must

personally cosign the loan.

increased these activities in the United States These changes have created a needfor financial managers who can help a firm to manage cash flows in different cur-rencies and protect against the risks that naturally arise from international trans-actions Although these changes make the managerial finance function more com-plex, they can also lead to a more rewarding and fulfilling career

Legal Forms of Business Organization

The three most common legal forms of business organization are the sole

propri-etorship, the partnership, and the corporation Other specialized forms of business

organization also exist Sole proprietorships are the most numerous However,corporations are overwhelmingly dominant with respect to receipts and net prof-its Corporations are given primary emphasis in this textbook

Sole Proprietorships

A sole proprietorship is a business owned by one person who operates it for his

or her own profit About 75 percent of all business firms are sole proprietorships.The typical sole proprietorship is a small business, such as a bike shop, personaltrainer, or plumber The majority of sole proprietorships are found in the whole-sale, retail, service, and construction industries

Typically, the proprietor, along with a few employees, operates the etorship He or she normally raises capital from personal resources or by borrow-

propri-ing and is responsible for all business decisions The sole proprietor has unlimited

liability; his or her total wealth, not merely the amount originally invested, can be

taken to satisfy creditors The key strengths and weaknesses of sole ships are summarized in Table 1.1

proprietor-Partnerships

A partnership consists of two or more owners doing business together for profit.

Partnerships account for about 10 percent of all businesses, and they are typicallylarger than sole proprietorships Finance, insurance, and real estate firms are themost common types of partnership Public accounting and stock brokerage part-nerships often have large numbers of partners

Most partnerships are established by a written contract known as articles of

partnership In a general (or regular) partnership, all partners have unlimited

lia-bility, and each partner is legally liable for all of the debts of the partnership.Strengths and weaknesses of partnerships are summarized in Table 1.1

Corporations

A corporation is an artificial being created by law Often called a “legal entity,” a

corporation has the powers of an individual in that it can sue and be sued, makeand be party to contracts, and acquire property in its own name Although onlyabout 15 percent of all businesses are incorporated, the corporation is the domi-nant form of business organization in terms of receipts and profits It accountsfor nearly 90 percent of business receipts and 80 percent of net profits Although

6 PART 1 Introduction to Managerial Finance

stockholders

The owners of a corporation,

whose ownership, or equity, is

evidenced by either common

stock or preferred stock.

common stock

The purest and most basic form

of corporate ownership.

dividends

Periodic distributions of earnings

to the stockholders of a firm.

board of directors

Group elected by the firm’s

stockholders and having ultimate

authority to guide corporate

affairs and make general policy.

1 Some corporations do not have stockholders but rather have “members” who often have rights similar to those of stockholders—that is, they are entitled to vote and receive dividends Examples include mutual savings banks, credit unions, mutual insurance companies, and a whole host of charitable organizations.

T A B L E 1 1 Strengths and Weaknesses of the Common Legal Forms

of Business Organization

Sole proprietorship Partnership Corporation

Strengths • Owner receives all profits (and • Can raise more funds than sole • Owners have limited liability,

sustains all losses) proprietorships which guarantees that they

can-• Low organizational costs • Borrowing power enhanced not lose more than they invested

• Income included and taxed on by more owners • Can achieve large size via sale proprietor’s personal tax return • More available brain power and of stock

• Independence managerial skill • Ownership (stock) is readily

• Secrecy • Income included and taxed transferable

• Ease of dissolution on partner’s tax return • Long life of firm

• Can hire professional managers

• Has better access to financing

• Receives certain tax advantages Weaknesses • Owner has unlimited liability— • Owners have unlimited liability • Taxes generally higher, because

total wealth can be taken to and may have to cover debts of corporate income is taxed, and satisfy debts other partners dividends paid to owners are also

• Limited fund-raising power tends • Partnership is dissolved when a taxed

to inhibit growth partner dies • More expensive to organize than

• Proprietor must be jack-of-all- • Difficult to liquidate or transfer other business forms trades partnership • Subject to greater government

• Difficult to give employees long- regulation run career opportunities • Lacks secrecy, because stock-

• Lacks continuity when proprietor holders must receive financial

corporations are involved in all types of businesses, manufacturing corporationsaccount for the largest portion of corporate business receipts and net profits Thekey strengths and weaknesses of large corporations are summarized in Table 1.1

The owners of a corporation are its stockholders, whose ownership, or

equity, is evidenced by either common stock or preferred stock.1These forms ofownership are defined and discussed in Chapter 7; at this point suffice it to say

that common stock is the purest and most basic form of corporate ownership Stockholders expect to earn a return by receiving dividends—periodic distribu-

tions of earnings—or by realizing gains through increases in share price

As noted in the upper portion of Figure 1.1, the stockholders vote periodically

to elect the members of the board of directors and to amend the firm’s corporate

charter The board of directors has the ultimate authority in guiding corporate

affairs and in making general policy The directors include key corporate nel as well as outside individuals who typically are successful businesspeople andexecutives of other major organizations Outside directors for major corporationsare generally paid an annual fee of $10,000 to $20,000 or more Also, they are

person-CHAPTER 1 The Role and Environment of Managerial Finance 7

president or chief

executive officer (CEO)

Corporate official responsible for

managing the firm’s day-to-day

operations and carrying out the

policies established by the board

Pension Fund Manager

Capital Expenditure Manager

Credit Manager

Foreign Exchange Manager

Corporate Accounting Manager

Financial Accounting Manager

Tax Manager Treasurer

Vice President Manufacturing

Vice President Human Resources

Vice President Finance (CFO)

President (CEO)

Board of Directors Owners

Vice President Information Resources

Controller

Cost Accounting Manager

frequently granted options to buy a specified number of shares of the firm’s stock

at a stated—and often attractive—price

The president or chief executive officer (CEO) is responsible for managing

day-to-day operations and carrying out the policies established by the board TheCEO is required to report periodically to the firm’s directors

It is important to note the division between owners and managers in a largecorporation, as shown by the dashed horizontal line in Figure 1.1 This separa-tion and some of the issues surrounding it will be addressed in the discussion of

the agency issue later in this chapter.

8 PART 1 Introduction to Managerial Finance

T A B L E 1 2 Other Limited Liability Organizations

Organization Description

Limited partnership (LP) A partnership in which one or more partners have limited liability as long as at least one

partner (the general partner) has unlimited liability The limited partners cannot take an

active role in the firm’s management; they are passive investors.

S corporation (S corp) A tax-reporting entity that (under Subchapter S of the Internal Revenue Code)

allows certain corporations with 75 or fewer stockholders to choose to be taxed as partnerships Its stockholders receive the organizational benefits of a corporation and the tax advantages of a partnership But S corps lose certain tax advantages related to pension plans.

Limited liability corporation (LLC) Permitted in most states, the LLC gives its owners, like those of S corps, limited liability

and taxation as a partnership But unlike an S corp, the LLC can own more than 80%

of another corporation, and corporations, partnerships, or non-U.S residents can own LLC shares LLCs work well for corporate joint ventures or projects developed through

a subsidiary.

Limited liability partnership (LLP)a A partnership permitted in many states; governing statutes vary by state All LLP

partners have limited liability They are liable for their own acts of malpractice, not for those of other partners The LLP is taxed as a partnership LLPs are frequently used by legal and accounting professionals.

a In recent years this organizational form has begun to replace professional corporations or associations—corporations formed by groups of

professionals such as attorneys and accountants that provide limited liability except for that related to malpractice—because of the tax advantages

it offers.

limited partnership (LP)

S corporation (S corp)

limited liability corporation (LLC)

limited liability partnership (LLP)

See Table 1.2.

Other Limited Liability Organizations

A number of other organizational forms provide owners with limited liability

The most popular are limited partnerships (LPs), S corporations (S corps), limited

liability corporations (LLCs), and limited liability partnerships (LLPs) Each

rep-resents a specialized form or blending of the characteristics of the organizationalforms described before What they have in common is that their owners enjoylimited liability, and they typically have fewer than 100 owners Each of theselimited liability organizations is briefly described in Table 1.2

The Study of Managerial Finance

An understanding of the theories, concepts, techniques, and practices presentedthroughout this text will fully acquaint you with the financial manager’s activitiesand decisions Because most business decisions are measured in financial terms,the financial manager plays a key role in the operation of the firm People in allareas of responsibility—accounting, information systems, management, market-ing, operations, and so forth—need a basic understanding of the managerialfinance function

All managers in the firm, regardless of their job descriptions, work with cial personnel to justify laborpower requirements, negotiate operating budgets,deal with financial performance appraisals, and sell proposals at least partly on thebasis of their financial merits Clearly, those managers who understand the finan-

finan-CHAPTER 1 The Role and Environment of Managerial Finance 9

T A B L E 1 3 Career Opportunities in Managerial Finance

Position Description

Financial analyst Primarily prepares the firm’s financial plans and budgets Other duties include financial

fore-casting, performing financial comparisons, and working closely with accounting.

Capital expenditures manager Evaluates and recommends proposed asset investments May be involved in the financial

aspects of implementing approved investments.

Project finance manager In large firms, arranges financing for approved asset investments Coordinates consultants,

investment bankers, and legal counsel.

Cash manager Maintains and controls the firm’s daily cash balances Frequently manages the firm’s cash

col-lection and disbursement activities and short-term investments; coordinates short-term ing and banking relationships.

borrow-Credit analyst/manager Administers the firm’s credit policy by evaluating credit applications, extending credit, and

monitoring and collecting accounts receivable.

Pension fund manager In large companies, oversees or manages the assets and liabilities of the employees’ pension

fund.

Foreign exchange manager Manages specific foreign operations and the firm’s exposure to fluctuations in exchange rates.

cial decision-making process will be better able to address financial concerns andwill therefore more often get the resources they need to attain their own goals The

“Across the Disciplines” element that appears on each chapter-opening pageshould help you understand some of the many interactions between managerialfinance and other business careers

As you study this text, you will learn about the career opportunities in agerial finance, which are briefly described in Table 1.3 Although this text focuses

man-on publicly held profit-seeking firms, the principles presented here are equallyapplicable to private and not-for-profit organizations The decision-making prin-ciples developed in this text can also be applied to personal financial decisions Ihope that this first exposure to the exciting field of finance will provide the foun-dation and initiative for further study and possibly even a future career

1–3 Which legal form of business organization is most common? Which form

is dominant in terms of business receipts and net profits?

1–4 Describe the roles and the basic relationship among the major parties in acorporation—stockholders, board of directors, and president How arecorporate owners compensated?

1–5 Briefly name and describe some organizational forms other than tions that provide owners with limited liability

corpora-1–6 Why is the study of managerial finance important regardless of the specificarea of responsibility one has within the business firm?

10 PART 1 Introduction to Managerial Finance

marginal analysis

Economic principle that states

that financial decisions should

be made and actions taken only

when the added benefits exceed

the added costs.

controller

The firm’s chief accountant, who

is responsible for the firm’s

accounting activities, such as

corporate accounting, tax

management, financial

account-ing, and cost accounting.

foreign exchange manager

The manager responsible for

monitoring and managing the

firm’s exposure to loss from

The firm’s chief financial

man-ager, who is responsible for the

firm’s financial activities, such

as financial planning and fund

raising, making capital

expendi-ture decisions, and managing

cash, credit, the pension fund,

and foreign exchange.

LG3

People in all areas of responsibility within the firm must interact with financepersonnel and procedures to get their jobs done For financial personnel tomake useful forecasts and decisions, they must be willing and able to talk toindividuals in other areas of the firm The managerial finance function can bebroadly described by considering its role within the organization, its relation-ship to economics and accounting, and the primary activities of the financialmanager

Organization of the Finance Function

The size and importance of the managerial finance function depend on the size ofthe firm In small firms, the finance function is generally performed by theaccounting department As a firm grows, the finance function typically evolvesinto a separate department linked directly to the company president or CEOthrough the chief financial officer (CFO) The lower portion of the organizationalchart in Figure 1.1 (on page 7) shows the structure of the finance function in atypical medium-to-large-size firm

Reporting to the CFO are the treasurer and the controller The treasurer (the

chief financial manager) is commonly responsible for handling financial ties, such as financial planning and fund raising, making capital expenditure deci-sions, managing cash, managing credit activities, managing the pension fund, and

activi-managing foreign exchange The controller (the chief accountant) typically

han-dles the accounting activities, such as corporate accounting, tax management,financial accounting, and cost accounting The treasurer’s focus tends to be more

external, the controller’s focus more internal The activities of the treasurer, or

financial manager, are the primary concern of this text.

If international sales or purchases are important to a firm, it may wellemploy one or more finance professionals whose job is to monitor and managethe firm’s exposure to loss from currency fluctuations A trained financial man-ager can “hedge,” or protect against such a loss, at reasonable cost by using a

variety of financial instruments These foreign exchange managers typically

report to the firm’s treasurer

Relationship to Economics

The field of finance is closely related to economics Financial managers mustunderstand the economic framework and be alert to the consequences of varyinglevels of economic activity and changes in economic policy They must also beable to use economic theories as guidelines for efficient business operation.Examples include supply-and-demand analysis, profit-maximizing strategies, andprice theory The primary economic principle used in managerial finance is

marginal analysis, the principle that financial decisions should be made and

actions taken only when the added benefits exceed the added costs Nearly allfinancial decisions ultimately come down to an assessment of their marginal ben-efits and marginal costs

CHAPTER 1 The Role and Environment of Managerial Finance 11

accrual basis

In preparation of financial

statements, recognizes revenue

at the time of sale and recognizes

expenses when they are

incurred.

cash basis

Recognizes revenues and

expenses only with respect to

actual inflows and outflows of

cash.

E X A M P L E Jamie Teng is a financial manager for Nord Department Stores, a large chain of

upscale department stores operating primarily in the western United States She iscurrently trying to decide whether to replace one of the firm’s online computerswith a new, more sophisticated one that would both speed processing and handle

a larger volume of transactions The new computer would require a cash outlay

of $80,000, and the old computer could be sold to net $28,000 The total fits from the new computer (measured in today’s dollars) would be $100,000.The benefits over a similar time period from the old computer (measured intoday’s dollars) would be $35,000 Applying marginal analysis, Jamie organizesthe data as follows:

bene-Because the marginal (added) benefits of $65,000 exceed the marginal (added)costs of $52,000, Jamie recommends that the firm purchase the new computer toreplace the old one The firm will experience a net benefit of $13,000 as a result

of this action

Relationship to Accounting

The firm’s finance (treasurer) and accounting (controller) activities are closelyrelated and generally overlap Indeed, managerial finance and accounting are notoften easily distinguishable In small firms the controller often carries out thefinance function, and in large firms many accountants are closely involved in var-ious finance activities However, there are two basic differences between financeand accounting; one is related to the emphasis on cash flows and the other todecision making

Emphasis on Cash Flows

The accountant’s primary function is to develop and report data for measuringthe performance of the firm, assessing its financial position, and paying taxes.Using certain standardized and generally accepted principles, the accountant pre-pares financial statements that recognize revenue at the time of sale (whether pay-ment has been received or not) and recognize expenses when they are incurred

This approach is referred to as the accrual basis.

The financial manager, on the other hand, places primary emphasis on cash

flows, the intake and outgo of cash He or she maintains the firm’s solvency by

plan-ning the cash flows necessary to satisfy its obligations and to acquire assets needed

to achieve the firm’s goals The financial manager uses this cash basis to recognize

the revenues and expenses only with respect to actual inflows and outflows of cash

Benefits with new computer $100,000 Less: Benefits with old computer

12 PART 1 Introduction to Managerial Finance

Hint The primary emphasis

of accounting is on accrual

methods; the primary emphasis

of financial management is on

cash flow methods.

Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet itsobligations as they come due

E X A M P L E Nassau Corporation, a small yacht dealer, sold one yacht for $100,000 in the

cal-endar year just ended The yacht was purchased during the year at a total cost of

$80,000 Although the firm paid in full for the yacht during the year, at year-end

it has yet to collect the $100,000 from the customer The accounting view and thefinancial view of the firm’s performance during the year are given by the follow-ing income and cash flow statements, respectively

In an accounting sense Nassau Corporation is profitable, but in terms ofactual cash flow it is a financial failure Its lack of cash flow resulted from theuncollected account receivable of $100,000 Without adequate cash inflows tomeet its obligations, the firm will not survive, regardless of its level of profits

As the example shows, accrual accounting data do not fully describe the cumstances of a firm Thus the financial manager must look beyond financialstatements to obtain insight into existing or developing problems Of course,accountants are well aware of the importance of cash flows, and financial man-agers use and understand accrual-based financial statements Nevertheless, thefinancial manager, by concentrating on cash flows, should be able to avoid insol-vency and achieve the firm’s financial goals

cir-Decision Making

The second major difference between finance and accounting has to do with

deci-sion making Accountants devote most of their attention to the collection and

presentation of financial data Financial managers evaluate the accounting

state-ments, develop additional data, and make decisions on the basis of their

assess-ment of the associated returns and risks Of course, this does not mean thataccountants never make decisions or that financial managers never gather data.Rather, the primary focuses of accounting and finance are distinctly different

Primary Activities of the Financial Manager

In addition to ongoing involvement in financial analysis and planning, the cial manager’s primary activities are making investment decisions and makingfinancing decisions Investment decisions determine both the mix and the type of

finan-Financial View (cash basis) Nassau Corporation Cash Flow Statement for the Year Ended 12/31

Cash inflow $ 0 Less: Cash outflow

80,000

Net cash flow ($

80,000)

Accounting View (accrual basis) Nassau Corporation Income Statement for the Year Ended 12/31

Sales revenue $100,000 Less: Costs

80,000

Net profit $

20,000

CHAPTER 1 The Role and Environment of Managerial Finance 13

earnings per share (EPS)

The amount earned during the

period on behalf of each

outstanding share of common

stock, calculated by dividing the

period’s total earnings available

for the firm’s common

stockhold-ers by the number of shares of

common stock outstanding.

Long-Term Funds

Current Assets

Making Investment Decisions

Making Financing Decisions

Current Liabilities Balance Sheet

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assets held by the firm Financing decisions determine both the mix and the type

of financing used by the firm These sorts of decisions can be conveniently viewed

in terms of the firm’s balance sheet, as shown in Figure 1.2 However, the sions are actually made on the basis of their cash flow effects on the overall value

deci-of the firm

R e v i e w Q u e s t i o n s

1–7 What financial activities is the treasurer, or financial manager, responsiblefor handling in the mature firm?

1–8 What is the primary economic principle used in managerial finance?

1–9 What are the major differences between accounting and finance withrespect to emphasis on cash flows and decision making?

1–10 What are the two primary activities of the financial manager that are

related to the firm’s balance sheet?

1.3 Goal of the Firm

As noted earlier, the owners of a corporation are normally distinct from its agers Actions of the financial manager should be taken to achieve the objectives

man-of the firm’s owners, its stockholders In most cases, if financial managers aresuccessful in this endeavor, they will also achieve their own financial and profes-sional objectives Thus financial managers need to know what the objectives ofthe firm’s owners are

Maximize Profit?

Some people believe that the firm’s objective is always to maximize profit Toachieve this goal, the financial manager would take only those actions that wereexpected to make a major contribution to the firm’s overall profits For eachalternative being considered, the financial manager would select the one that isexpected to result in the highest monetary return

Corporations commonly measure profits in terms of earnings per share

(EPS), which represent the amount earned during the period on behalf of each

outstanding share of common stock EPS are calculated by dividing the period’stotal earnings available for the firm’s common stockholders by the number ofshares of common stock outstanding

14 PART 1 Introduction to Managerial Finance

2 Another criticism of profit maximization is the potential for profit manipulation through the creative use of tive accounting practices.

elec-E X A M P L elec-E Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of

marine engine components, is choosing between two investments, Rotor andValve The following table shows the EPS that each investment is expected tohave over its 3-year life

In terms of the profit maximization goal, Valve would be preferred overRotor, because it results in higher total earnings per share over the 3-year period($3.00 EPS compared with $2.80 EPS)

But is profit maximization a reasonable goal? No It fails for a number ofreasons: It ignores (1) the timing of returns, (2) cash flows available to stockhold-ers, and (3) risk.2

Timing

Because the firm can earn a return on funds it receives, the receipt of funds sooner

rather than later is preferred In our example, in spite of the fact that the total

earnings from Rotor are smaller than those from Valve, Rotor provides muchgreater earnings per share in the first year The larger returns in year 1 could bereinvested to provide greater future earnings

Cash Flows

Profits do not necessarily result in cash flows available to the stockholders

Own-ers receive cash flow in the form of either cash dividends paid them or the ceeds from selling their shares for a higher price than initially paid Greater EPS

pro-do not necessarily mean that a firm’s board of directors will vote to increase dend payments

divi-Furthermore, higher EPS do not necessarily translate into a higher stockprice Firms sometimes experience earnings increases without any correspond-ingly favorable change in stock price Only when earnings increases are accompa-nied by increased future cash flows would a higher stock price be expected Forexample, a firm in a highly competitive technology-driven business could increaseits earnings by significantly reducing its research and development expenditures

As a result the firm’s expenses would be reduced, thereby increasing its profits.But because of its impaired competitive position, the firm’s stock price woulddrop, as many well-informed investors sell the stock in recognition of lowerfuture cash flows In this case, the earnings increase was accompanied by lowerfuture cash flows and therefore a lower stock price

Earnings per share (EPS) Investment Year 1 Year 2 Year 3 Total for years 1, 2, and 3

Rotor $1.40 $1.00 $0.40 $2.80 Valve 0.60 1.00 1.40 3.00

CHAPTER 1 The Role and Environment of Managerial Finance 15

Hint This is one of the

most important concepts in the

book Investors who seek to

avoid risk will always require a

bigger reward for taking bigger

risks.

risk

The chance that actual outcomes

may differ from those expected.

Return?

Risk?

Financial Decision Alternative

No

Risk

Profit maximization also disregards risk—the chance that actual outcomes may

differ from those expected A basic premise in managerial finance is that a tradeoff

exists between return (cash flow) and risk Return and risk are in fact the key

determinants of share price, which represents the wealth of the owners in the firm.

Cash flow and risk affect share price differently: Higher cash flow is ally associated with a higher share price Higher risk tends to result in a lowershare price because the stockholder must be compensated for the greater risk Forexample, if a lawsuit claiming significant damages is filed against a company, itsshare price typically will drop immediately This occurs not because of any near-term cash flow reduction but in response to the firm’s increased risk—there’s achance that the firm will have to pay out a large amount of cash some time in thefuture to eliminate or fully satisfy the claim Simply put, the increased risk

gener-reduces the firm’s share price In general, stockholders are risk-averse—that is,

they want to avoid risk When risk is involved, stockholders expect to earn higherrates of return on investments of higher risk and lower rates on lower-risk invest-ments The key point, which will be fully developed in Chapter 5, is that differ-ences in risk can significantly affect the value of an investment

Because profit maximization does not achieve the objectives of the firm’s

owners, it should not be the goal of the financial manager.

Maximize Shareholder Wealth

The goal of the firm, and therefore of all managers and employees, is to maximize

the wealth of the owners for whom it is being operated The wealth of corporate

owners is measured by the share price of the stock, which in turn is based on thetiming of returns (cash flows), their magnitude, and their risk When consideringeach financial decision alternative or possible action in terms of its impact on the

share price of the firm’s stock, financial managers should accept only those

actions that are expected to increase share price Figure 1.3 depicts this process.

Because share price represents the owners’ wealth in the firm, maximizing share

price will maximize owner wealth Note that return (cash flows) and risk are the

key decision variables in maximizing owner wealth It is important to recognize

that earnings per share (EPS), because they are viewed as an indicator of the

16 PART 1 Introduction to Managerial Finance

3 For a good summary of economic value added (EVA ® ), see Shaun Tully, “The Real Key to Creating Wealth,”

Fortune (September 20, 1993), pp 38–49.

economic value added (EVA ® )

A popular measure used by many

firms to determine whether an

investment contributes positively

to the owners’ wealth;

calculated by subtracting the

cost of funds used to finance an

investment from its after-tax

operating profits.

In Practice

Once a small Northwest thrift,

Washington Mutual (WaMu) is

now the nation’s largest savings

institution and the seventh largest

U.S bank Its financial

perfor-mance has been as exceptional as

its rapid growth Under the

finan-cial leadership of CFO William

Longbrake, its assets grew 10-fold

(to $220 billion) in a recent 5-year

period, earnings rose an average

of 18.6 percent per year, and the

stock price nearly tripled.

How has WaMu’s

manage-ment team increased shareholder

value so much? Four major

acqui-sitions played an important role in

adding branch networks Greater

penetration in existing markets has

also been a driver Another

differ-entiating factor is the “pay for

per-formance” plan that Longbrake

introduced The compensation

plan encourages all employees,

from managers to tellers, to

cross-sell products and to give mers the highest level of service possible As a result, the number of customers and the profits per cus- tomer have soared, helped along

custo-by a clever advertising campaign that emphasizes WaMu’s personal service.

But it’s not enough to grow revenues if expenses aren’t under control At the same time as its revenues grew, the bank’s operat- ing efficiency improved signifi- cantly, the best among WaMu’s major competitors.

Longbrake and his financial managers continually look for ways to boost revenues and improve earnings A successful campaign to increase noninterest income from depositor and other retail banking fees, which are not subject to interest-rate move- ments, lessened the effect on earnings of changes in interest

rates Another strategy was to sell off all but the most profitable single-family mortgages in the bank’s loan portfolio In spite of interest-rate fluctuations in 2000, WaMu earned $1.9 billion—its most profitable year ever The bank continued to post record results in 2001, as interest rates fell, by increasing mortgage origi- nation and refinancing activities.

As a result, the firm even increased cash dividends at a time when many companies were cut- ting them Clearly, Longbrake and his managers’ actions were effec- tive in creating value for WaMu’s shareholders.

Sources: Adapted from Stephen Barr, “The

Revenue Revolution at Washington Mutual,”

CFO, October 2001, downloaded from www.cfo.com; “Washington Mutual Profits Rise 84 Percent,” October 16, 2001, Reuters Business Report, downloaded from eLibrary, ask.elibrary.com; Washington Mutual Web site, www.wamu.com.

firm’s future returns (cash flows), often appear to affect share price Two tant issues related to maximizing share price are economic value added (EVA®)and the focus on stakeholders

impor-Economic Value Added (EVA ® )

Economic value added (EVA ® ) is a popular measure used by many firms to

deter-mine whether an investment—proposed or existing—contributes positively to theowners’ wealth.3 EVA® is calculated by subtracting the cost of funds used tofinance an investment from its after-tax operating profits Investments with posi-tive EVA®s increase shareholder value and those with negative EVA®s reduceshareholder value Clearly, only those investments with positive EVA®s are desir-able For example, the EVA®of an investment with after-tax operating profits of

$410,000 and associated financing costs of $375,000 would be $35,000 (i.e.,

$410,000$375,000) Because this EVA®is positive, the investment is expected

to increase owner wealth and is therefore acceptable (EVA®-type models are cussed in greater detail as part of the coverage of stock valuation in Chapter 7.)

dis-CHAPTER 1 The Role and Environment of Managerial Finance 17

stakeholders

Groups such as employees,

customers, suppliers, creditors,

owners, and others who have a

direct economic link to the firm.

ethics

Standards of conduct or moral

judgment.

4 Robert A Cooke, “Business Ethics: A Perspective,” in Arthur Andersen Cases on Business Ethics (Chicago:

Arthur Andersen, September 1991), pp 2 and 5.

What About Stakeholders?

Although maximization of shareholder wealth is the primary goal, many firms

broaden their focus to include the interests of stakeholders as well as shareholders.

Stakeholders are groups such as employees, customers, suppliers, creditors, owners,

and others who have a direct economic link to the firm A firm with a stakeholder

focus consciously avoids actions that would prove detrimental to stakeholders The

goal is not to maximize stakeholder well-being but to preserve it

The stakeholder view does not alter the goal of maximizing shareholderwealth Such a view is often considered part of the firm’s “social responsibility.”

It is expected to provide long-run benefit to shareholders by maintaining positivestakeholder relationships Such relationships should minimize stakeholderturnover, conflicts, and litigation Clearly, the firm can better achieve its goal ofshareholder wealth maximization by fostering cooperation with its other stake-holders, rather than conflict with them

The Role of Ethics

In recent years, the ethics of actions taken by certain businesses have received majormedia attention Examples include an agreement by American Express Co in early

2002 to pay $31 million to settle a sex- and age-discrimination lawsuit filed onbehalf of more than 4,000 women who said they were denied equal pay and pro-motions; Enron Corp.’s key executives indicating to employee-shareholders in mid-

2001 that the firm’s then-depressed stock price would soon recover while, at thesame time, selling their own shares and, not long after, taking the firm into bank-ruptcy; and Liggett & Meyers’ early 1999 agreement to fund the payment of morethan $1 billion in smoking-related health claims

Clearly, these and similar actions have raised the question of ethics—standards

of conduct or moral judgment Today, the business community in general and thefinancial community in particular are developing and enforcing ethical standards.The goal of these ethical standards is to motivate business and market participants

to adhere to both the letter and the spirit of laws and regulations concerned withbusiness and professional practice Most business leaders believe businesses actu-ally strengthen their competitive positions by maintaining high ethical standards

Considering Ethics

Robert A Cooke, a noted ethicist, suggests that the following questions be used

to assess the ethical viability of a proposed action.4

1 Is the action arbitrary or capricious? Does it unfairly single out an individual

or group?

2 Does the action violate the moral or legal rights of any individual or group?

3 Does the action conform to accepted moral standards?

4 Are there alternative courses of action that are less likely to cause actual orpotential harm?

18 PART 1 Introduction to Managerial Finance

In Practice

Hewlett-Packard (H-P) was

founded in 1939 by Bill Hewlett and

Dave Packard on the basis of

prin-ciples of fair dealing and

respect—long before anyone

coined the expression “corporate

social responsibility.” H-P credits

its ongoing commitment to “doing

well by doing good” as a major

reason why employees, suppliers,

customers, and shareholders seek

it out H-P is clear on its obligation

to increase the market value of its

common stock, yet it strives to

maintain the integrity of each

employee in every country in

which it does business Its

“Standards of Business Conduct”

include a provision that triggers

immediate dismissal of any

employee who is found to have

told a lie Its internal auditors are

expected to adhere to all of these

standards, which set forth the

“highest principles of business

ethics and conduct,” according to H-P’s 2000 annual report.

Maximizing shareholder wealth is what some call a “moral imperative,” in that stockholders are owners with property rights, and in that managers as stewards are obliged to look out for owners’

interests Many times, doing what

is right is consistent with ing the stock price, but what if integrity causes a company to lose

maximiz-a contrmaximiz-act or cmaximiz-auses maximiz-anmaximiz-alysts to reduce the rating of the stock from

“buy” to “sell”? The objective to maximize shareholder wealth holds, but company officers must

do so within ethical constraints.

Those constraints occasionally limit the alternative actions from which managers may choose.

Some critics have mistakenly assumed that the objective of max- imizing shareholder wealth is somehow the cause of unethical

behavior, ignoring the fact that any

business goal might be cited as a factor pressuring individuals to be unethical.

U.S business professionals have tended to operate from within

a strong moral framework based

on early-childhood moral ment that takes place in families and religious institutions This does not prevent all ethical lapses, obviously But it is not surprising that chief financial officers declare that the number-1 personal attribute that finance grads need is ethics—which they rank above interpersonal skills, communica- tion skills, decision-making ability, and computer skills H-P is aware

develop-of this need and has ized it in the company’s culture and policies.

Clearly, considering such questions before taking an action can help toensure its ethical viability Specifically, Cooke suggests that the impact of a pro-posed decision should be evaluated from a number of perspectives before it isfinalized:

1 Are the rights of any stakeholder being violated?

2 Does the firm have any overriding duties to any stakeholder?

3 Will the decision benefit any stakeholder to the detriment of anotherstakeholder?

4 If there is detriment to any stakeholder, how should this be remedied, if atall?

5 What is the relationship between stockholders and other stakeholders?Today, more and more firms are directly addressing the issue of ethics byestablishing corporate ethics policies and requiring employee compliance withthem Frequently, employees are required to sign a formal pledge to uphold thefirm’s ethics policies Such policies typically apply to employee actions in dealingwith all corporate stakeholders, including the public Many companies alsorequire employees to participate in ethics seminars and training programs Toprovide further insight into the ethical dilemmas and issues sometimes facing the

CHAPTER 1 The Role and Environment of Managerial Finance 19

agency problem

The likelihood that managers

may place personal goals ahead

of corporate goals.

5 For an excellent discussion of this and related issues by a number of finance academics and practitioners who have

given a lot of thought to financial ethics, see James S Ang, “On Financial Ethics,” Financial Management (Autumn

1993), pp 32–59.

6 The agency problem and related issues were first addressed by Michael C Jensen and William H Meckling,

“The-ory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3

(October 1976), pp 305–306 For an excellent discussion of Jensen and Meckling and subsequent research on the

agency problem, see William L Megginson, Corporate Finance Theory (Boston, MA: Addison Wesley, 1997),

Chapter 2.

Hint A stockbroker

confronts the same issue If she

gets you to buy and sell more

stock, it’s good for her, but it

may not be good for you.

financial manager, a number of the In Practice boxes appearing throughout this

book are labeled to note their focus on ethics

Ethics and Share Price

An effective ethics program is believed to enhance corporate value An ethics gram can produce a number of positive benefits It can reduce potential litigationand judgment costs; maintain a positive corporate image; build shareholder confi-dence; and gain the loyalty, commitment, and respect of the firm’s stakeholders.Such actions, by maintaining and enhancing cash flow and reducing perceived

pro-risk, can positively affect the firm’s share price Ethical behavior is therefore

viewed as necessary for achieving the firm’s goal of owner wealth maximization.5

The Agency Issue

We have seen that the goal of the financial manager should be to maximize the

wealth of the firm’s owners Thus managers can be viewed as agents of the

own-ers who have hired them and given them decision-making authority to managethe firm Technically, any manager who owns less than 100 percent of the firm is

to some degree an agent of the other owners This separation of owners and agers is shown by the dashed horizontal line in Figure 1.1 on page 7

man-In theory, most financial managers would agree with the goal of ownerwealth maximization In practice, however, managers are also concerned withtheir personal wealth, job security, and fringe benefits Such concerns may makemanagers reluctant or unwilling to take more than moderate risk if they perceivethat taking too much risk might jeopardize their jobs or reduce their personalwealth The result is a less-than-maximum return and a potential loss of wealthfor the owners

The Agency Problem

From this conflict of owner and personal goals arises what has been called the

agency problem, the likelihood that managers may place personal goals ahead of

corporate goals.6Two factors—market forces and agency costs—serve to prevent

or minimize agency problems

Market Forces One market force is major shareholders, particularly large

institutional investors such as mutual funds, life insurance companies, andpension funds These holders of large blocks of a firm’s stock exert pressure onmanagement to perform When necessary, they exercise their voting rights asstockholders to replace underperforming management

20 PART 1 Introduction to Managerial Finance

agency costs

The costs borne by stockholders

to minimize agency problems.

incentive plans

Management compensation

plans that tend to tie

manage-ment compensation to share

price; most popular incentive

plan involves the grant of stock

options.

stock options

An incentive allowing managers

to purchase stock at the market

price set at the time of the grant.

performance plans

Plans that tie management

compensation to measures such

as EPS, growth in EPS, and other

ratios of return Performance

shares and/or cash bonuses are

used as compensation under

these plans.

performance shares

Shares of stock given to

manage-ment for meeting stated

perfor-mance goals.

cash bonuses

Cash paid to management for

achieving certain performance

goals.

7 Detailed discussion of the important aspects of corporate takeovers is included in Chapter 17, “Mergers, LBOs, Divestitures, and Business Failure.”

Another market force is the threat of takeover by another firm that believes it

can enhance the target firm’s value to restructuring its management, operations,and financing.7The constant threat of a takeover tends to motivate management

to act in the best interests of the firm’s owners

Agency Costs To minimize agency problems and contribute to the

maxi-mization of owners’ wealth, stockholders incur agency costs These are the costs

of monitoring management behavior, ensuring against dishonest acts of ment, and giving managers the financial incentive to maximize share price

The most popular, powerful, and expensive approach is to structure

manage-ment compensation to correspond with share price maximization The objective

is to give managers incentives to act in the best interests of the owners In tion, the resulting compensation packages allow firms to compete for and hire thebest managers available The two key types of compensation plans are incentiveplans and performance plans

addi-Incentive plans tend to tie management compensation to share price The

most popular incentive plan is the granting of stock options to management.

These options allow managers to purchase stock at the market price set at thetime of the grant If the market price rises, managers will be rewarded by beingable to resell the shares at the higher market price

Many firms also offer performance plans, which tie management

compensa-tion to measures such as earnings per share (EPS), growth in EPS, and other

ratios of return Performance shares, shares of stock given to management as a

result of meeting the stated performance goals, are often used in these plans

Another form of performance-based compensation is cash bonuses, cash

pay-ments tied to the achievement of certain performance goals

The Current View of Management Compensation

The execution of many compensation plans has been closely scrutinized in recentyears Both individuals and institutional stockholders, as well as the Securitiesand Exchange Commission (SEC), have publicly questioned the appropriateness

of the multimillion-dollar compensation packages that many corporate executivesreceive For example, the three highest-paid CEOs in 2001 were (1) LawrenceEllison, of Oracle, who earned $706.1 million; (2) Jozef Straus, of JDS Uniphase,who earned $150.8 million; and (3) Howard Solomon, of Forest Laboratories,who earned $148.5 million Tenth on the same list was Timothy Koogle, ofYahoo!, who earned $64.6 million During 2001, the compensation of the averageCEO of a major U.S corporation declined by about 16 percent from 2000 CEOs

of 365 of the largest U.S companies surveyed by Business Week, using data from

Standard & Poor’s EXECUCOMP, earned an average of $11 million in total pensation; the average for the 20 highest paid CEOs was $112.5 million

Recent studies have failed to find a strong relationship between CEO pensation and share price Publicity surrounding these large compensation pack-ages (without corresponding share price performance) is expected to drive down

com-CHAPTER 1 The Role and Environment of Managerial Finance 21

financial institution

An intermediary that channels

the savings of individuals,

businesses, and governments

into loans or investments.

Hint Think about how

inefficient it would be if each

individual saver had to

negotiate with each potential

user of savings Institutions

make the process very efficient

Unconstrained, managers may have other goals in addition to share pricemaximization, but much of the evidence suggests that share price maximiza-tion—the focus of this book—is the primary goal of most firms

R e v i e w Q u e s t i o n s

1–11 For what three basic reasons is profit maximization inconsistent with

wealth maximization?

1–12 What is risk? Why must risk as well as return be considered by the

finan-cial manager who is evaluating a decision alternative or action?

1–13 What is the goal of the firm and therefore of all managers and employees?

Discuss how one measures achievement of this goal

1–14 What is economic value added (EVA ® )? How is it used?

1–15 Describe the role of corporate ethics policies and guidelines, and discuss

the relationship that is believed to exist between ethics and share price

1–16 How do market forces, both shareholder activism and the threat of

takeover, act to prevent or minimize the agency problem?

1–17 Define agency costs, and explain why firms incur them How can

manage-ment structure managemanage-ment compensation to minimize agency problems?

What is the current view with regard to the execution of many tion plans?

compensa-1.4 Financial Institutions and Markets

Most successful firms have ongoing needs for funds They can obtain funds from

external sources in three ways One is through a financial institution that accepts savings and transfers them to those that need funds Another is through financial

markets, organized forums in which the suppliers and demanders of various types

of funds can make transactions A third is through private placement Because of

the unstructured nature of private placements, here we focus primarily on cial institutions and financial markets

finan-Financial Institutions

Financial institutions serve as intermediaries by channeling the savings of

individ-uals, businesses, and governments into loans or investments Many financialinstitutions directly or indirectly pay savers interest on deposited funds; othersprovide services for a fee (for example, checking accounts for which customerspay service charges) Some financial institutions accept customers’ savingsdeposits and lend this money to other customers or to firms; others invest

22 PART 1 Introduction to Managerial Finance

financial markets

Forums in which suppliers of

funds and demanders of funds

can transact business directly.

private placement

The sale of a new security issue,

typically bonds or preferred

stock, directly to an investor or

group of investors.

public offering

The nonexclusive sale of either

bonds or stocks to the general

public.

W WW

customers’ savings in earning assets such as real estate or stocks and bonds; andsome do both Financial institutions are required by the government to operatewithin established regulatory guidelines

Key Customers of Financial Institutions

The key suppliers of funds to financial institutions and the key demanders offunds from financial institutions are individuals, businesses, and governments.The savings that individual consumers place in financial institutions providethese institutions with a large portion of their funds Individuals not only supplyfunds to financial institutions but also demand funds from them in the form of

loans However, individuals as a group are the net suppliers for financial

institu-tions: They save more money than they borrow

Business firms also deposit some of their funds in financial institutions, marily in checking accounts with various commercial banks Like individuals,

pri-firms also borrow funds from these institutions, but pri-firms are net demanders of

funds They borrow more money than they save

Governments maintain deposits of temporarily idle funds, certain tax ments, and Social Security payments in commercial banks They do not borrow

pay-funds directly from financial institutions, although by selling their debt securities

to various institutions, governments indirectly borrow from them The

govern-ment, like business firms, is typically a net demander of funds It typically

bor-rows more than it saves We’ve all heard about the federal budget deficit

Major Financial Institutions

The major financial institutions in the U.S economy are commercial banks, ings and loans, credit unions, savings banks, insurance companies, pension funds,and mutual funds These institutions attract funds from individuals, businesses,and governments, combine them, and make loans available to individuals andbusinesses Descriptions of the major financial institutions are found at the text-book’s Web site at www.aw.com/gitman

sav-Financial Markets

Financial markets are forums in which suppliers of funds and demanders of funds

can transact business directly Whereas the loans and investments of institutionsare made without the direct knowledge of the suppliers of funds (savers), suppli-ers in the financial markets know where their funds are being lent or invested.The two key financial markets are the money market and the capital market.Transactions in short-term debt instruments, or marketable securities, take place

in the money market Long-term securities—bonds and stocks—are traded in the

capital market.

To raise money, firms can use either private placements or public offerings

Private placement involves the sale of a new security issue, typically bonds or

pre-ferred stock, directly to an investor or group of investors, such as an insurance

company or pension fund Most firms, however, raise money through a public

offering of securities, which is the nonexclusive sale of either bonds or stocks to

the general public

CHAPTER 1 The Role and Environment of Managerial Finance 23

primary market

Financial market in which

securities are initially issued; the

only market in which the issuer

is directly involved in the

transaction.

secondary market

Financial market in which

preowned securities (those that

are not new issues) are traded.

money market

A financial relationship created

between suppliers and

demanders of short-term funds.

marketable securities

Short-term debt instruments,

such as U.S Treasury bills,

commercial paper, and

negotiable certificates of deposit

issued by government, business,

and financial institutions,

respectively.

F I G U R E 1 4

Flow of Funds

Flow of funds for financial

institutions and markets

Private Placement

Financial Markets

Funds

Deposits/Shares

Funds Loans

All securities are initially issued in the primary market This is the only

mar-ket in which the corporate or government issuer is directly involved in the action and receives direct benefit from the issue That is, the company actuallyreceives the proceeds from the sale of securities Once the securities begin to trade

trans-between savers and investors, they become part of the secondary market The

pri-mary market is the one in which “new” securities are sold The secondary marketcan be viewed as a “preowned” securities market

The Relationship Between Institutions and Markets

Financial institutions actively participate in the financial markets as both suppliersand demanders of funds Figure 1.4 depicts the general flow of funds through andbetween financial institutions and financial markets; private placement transac-tions are also shown The individuals, businesses, and governments that supplyand demand funds may be domestic or foreign We next briefly discuss the money

market, including its international equivalent—the Eurocurrency market We then

end this section with a discussion of the capital market, which is of key importance

to the firm

The Money Market

The money market is created by a financial relationship between suppliers and

demanders of short-term funds (funds with maturities of one year or less) The

money market exists because some individuals, businesses, governments, andfinancial institutions have temporarily idle funds that they wish to put to someinterest-earning use At the same time, other individuals, businesses, govern-ments, and financial institutions find themselves in need of seasonal or temporaryfinancing The money market brings together these suppliers and demanders ofshort-term funds

Most money market transactions are made in marketable

securities—short-term debt instruments, such as U.S Treasury bills, commercial paper, and

24 PART 1 Introduction to Managerial Finance

federal funds

Loan transactions between

commercial banks in which the

Federal Reserve banks become

involved.

Eurocurrency market

International equivalent of the

domestic money market.

London Interbank Offered Rate

(LIBOR)

The base rate that is used to

price all Eurocurrency loans.

Hint Remember that the

money market is for short-term

fund raising and is represented

by current liabilities on the

balance sheet The capital

market is for long-term fund

raising and is reflected by

long-term debt and equity on the

balance sheet.

negotiable certificates of deposit issued by government, business, and financialinstitutions, respectively (Marketable securities are described in Chapter 14.)

The Operation of the Money Market

The money market is not an actual organization housed in some central location.How, then, are suppliers and demanders of short-term funds brought together?Typically, they are matched through the facilities of large New York banks andthrough government securities dealers A number of stock brokerage firms pur-chase money market instruments for resale to customers Also, financial institu-tions purchase money market instruments for their portfolios in order to provideattractive returns on their customers’ deposits and share purchases Additionally,the Federal Reserve banks become involved in loans from one commercial bank

to another; these loans are referred to as transactions in federal funds.

In the money market, businesses and governments demand short-term funds

(borrow) by issuing a money market instrument Parties who supply short-term funds (invest) purchase the money market instruments To issue or purchase a

money market instrument, one party must go directly to another party or use anintermediary, such as a bank or brokerage firm, to make the transaction The sec-ondary (resale) market for marketable securities is no different from the primary(initial issue) market with respect to the basic transactions that are made Individ-uals also participate in the money market as purchasers and sellers of money mar-ket instruments Although individuals do not issue marketable securities, theymay sell them in the money market to liquidate them prior to maturity

The Eurocurrency Market

The international equivalent of the domestic money market is called the

Eurocurrency market This is a market for short-term bank deposits

denomi-nated in U.S dollars or other easily convertible currencies Historically, theEurocurrency market has been centered in London, but it has evolved into atruly global market

Eurocurrency deposits arise when a corporation or individual makes a bankdeposit in a currency other than the local currency of the country where the bank

is located If, for example, a multinational corporation were to deposit U.S lars in a London bank, this would create a Eurodollar deposit (a dollar deposit at

dol-a bdol-ank in Europe) Nedol-arly dol-all Eurodolldol-ar deposits dol-are time deposits This medol-ans

that the bank would promise to repay the deposit, with interest, at a fixed date inthe future—say, in 6 months During the interim, the bank is free to lend thisdollar deposit to creditworthy corporate or government borrowers If the bankcannot find a borrower on its own, it may lend the deposit to another interna-

tional bank The rate charged on these “interbank loans” is called the London

Interbank Offered Rate (LIBOR), and this is the base rate that is used to price all

Eurocurrency loans

The Eurocurrency market has grown rapidly, primarily because it is anunregulated, wholesale, and global market that fills the needs of both borrowersand lenders Investors with excess cash to lend are able to make large, short-term,and safe deposits at attractive interest rates Likewise, borrowers are able toarrange large loans, quickly and confidentially, also at attractive interest rates

CHAPTER 1 The Role and Environment of Managerial Finance 25

capital market

A market that enables suppliers

and demanders of long-term

funds to make transactions.

bond

Long-term debt instrument used

by business and government to

raise large sums of money,

generally from a diverse group of

lenders.

preferred stock

A special form of ownership

having a fixed periodic dividend

that must be paid prior to

payment of any common stock

dividends.

securities exchanges

Organizations that provide the

marketplace in which firms can

raise funds through the sale of

new securities and purchasers

can resell securities.

organized securities exchanges

Tangible organizations that act

as secondary markets where

outstanding securities are

resold.

The Capital Market

The capital market is a market that enables suppliers and demanders of long-term

funds to make transactions Included are securities issues of business and

govern-ment The backbone of the capital market is formed by the various securities

exchanges that provide a forum for bond and stock transactions.

Key Securities Traded: Bonds and Stocks

The key capital market securities are bonds (long-term debt) and both common

and preferred stock (equity, or ownership) Bonds are long-term debt instruments

used by business and government to raise large sums of money, generally from a

diverse group of lenders Corporate bonds typically pay interest semiannually (every 6 months) at a stated coupon interest rate They have an initial maturity of from 10 to 30 years, and a par, or face, value of $l,000 that must be repaid at

maturity Bonds are described in detail in Chapter 6

E X A M P L E Lakeview Industries, a major microprocessor manufacturer, has issued a 9

per-cent coupon interest rate, 20-year bond with a $1,000 par value that pays interestsemiannually Investors who buy this bond receive the contractual right to $90annual interest (9% coupon interest rate$1,000 par value) distributed as $45

at the end of each 6 months (1/2$90) for 20 years, plus the $1,000 par value atthe end of year 20

As noted earlier, shares of common stock are units of ownership, or equity,

in a corporation Common stockholders earn a return by receiving dividends—

periodic distributions of earnings—or by realizing increases in share price

Pre-ferred stock is a special form of ownership that has features of both a bond and

common stock Preferred stockholders are promised a fixed periodic dividendthat must be paid prior to payment of any dividends to common stockholders Inother words, preferred stock has “preference” over common stock Preferred andcommon stock are described in detail in Chapter 7

Major Securities Exchanges

Securities exchanges provide the marketplace in which firms can raise funds

through the sale of new securities and purchasers of securities can easily resellthem when necessary Many people call securities exchanges “stock markets,”but this label is misleading because bonds, common stock, preferred stock, and avariety of other investment vehicles are all traded on these exchanges The twokey types of securities exchanges are the organized exchange and the over-the-counter exchange In addition, important markets exist outside the UnitedStates

Organized Securities Exchanges Organized securities exchanges are

tangi-ble organizations that act as secondary markets where outstanding securities are resold Organized exchanges account for about 46 percent of the total dollar vol-

ume of domestic shares traded The best-known organized exchanges are the

New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX),

26 PART 1 Introduction to Managerial Finance

over-the-counter (OTC) exchange

An intangible market for the

purchase and sale of securities

not listed by the organized

exchanges.

Eurobond market

The market in which

corpora-tions and governments typically

issue bonds denominated in

dollars and sell them to investors

located outside the United

States.

both headquartered in New York City There are also regional exchanges, such

as the Chicago Stock Exchange and the Pacific Stock Exchange

Most exchanges are modeled after the New York Stock Exchange, whichaccounts for about 93 percent of the total annual dollar volume of shares traded

on organized U.S exchanges In order for a firm’s securities to be listed for

trad-ing on an organized exchange, a firm must file an application for listtrad-ing and meet

a number of requirements For example, to be eligible for listing on the NYSE, afirm must have at least 2,000 stockholders owning 100 or more shares; a mini-mum of 1.1 million shares of publicly held stock; pretax earnings of at least $6.5million over the previous 3 years, with no loss in the previous 2 years; and a min-imum of $100 million in stockholders’ equity Clearly, only large, widely heldfirms are candidates for NYSE listing

To make transactions on the “floor” of the New York Stock Exchange, anindividual or firm must own a “seat” on the exchange There are a total of 1,366seats on the NYSE, most of which are owned by brokerage firms Trading is car-

ried out on the floor of the exchange through an auction process The goal of ing is to fill buy orders at the lowest price and to fill sell orders at the highest price,

trad-thereby giving both purchasers and sellers the best possible deal

Once placed, an order to buy or sell can be executed in minutes, thanks tosophisticated telecommunication devices New Internet-based brokerage systemsenable investors to place their buy and sell orders electronically Information on

publicly traded securities is reported in various media, both print, such as the Wall

Street Journal, and electronic, such as MSN Money Central Investor (www moneycentral.msn.com).

The Over-the-Counter Exchange The over-the-counter (OTC) exchange is

an intangible market for the purchase and sale of securities not listed by the

orga-nized exchanges OTC traders, known as dealers, are linked with the purchasers and sellers of securities through the National Association of Securities Dealers

Automated Quotation (Nasdaq) system.

This sophisticated telecommunications network provides current bid and ask

prices on thousands of actively traded OTC securities The bid price is the highest price offered by a dealer to purchase a given security, and the ask price is the low-

est price at which the dealer is willing to sell the security The dealer in effect addssecurities to his or her inventory by purchasing them at the bid price and sellssecurities from the inventory at the ask price The dealer expects to profit from

the spread between the bid and ask prices Unlike the auction process on the

organized securities exchanges, the prices at which securities are traded in theOTC market result from both competitive bids and negotiation

Unlike the organized exchanges, the OTC handles both outstanding ties and new public issues, making it both a secondary and a primary market The OTC accounts for about 54 percent of the total dollar volume of domestic shares

securi-traded

International Capital Markets Although U.S capital markets are by far the

world’s largest, there are important debt and equity markets outside the United

States In the Eurobond market, corporations and governments typically issue

bonds denominated in dollars and sell them to investors located outside theUnited States A U.S corporation might, for example, issue dollar-denominated

CHAPTER 1 The Role and Environment of Managerial Finance 27

international equity market

A market that allows

corpora-tions to sell blocks of shares to

investors in a number of different

countries simultaneously.

efficient market

A market that allocates funds to

their most productive uses as a

result of competition among

wealth-maximizing investors that

determines and publicizes prices

that are believed to be close to

their true value.

foreign bond

Bond that is issued by a foreign

corporation or government and is

denominated in the investor’s

home currency and sold in the

investor’s home market.

D0S

F I G U R E 1 5 Supply and Demand

Supply and demand for a security

bonds that would be purchased by investors in Belgium, Germany, or Switzerland.Through the Eurobond market, issuing firms and governments can tap a muchlarger pool of investors than would be generally available in the local market.The foreign bond market is another international market for long-term debt

securities A foreign bond is a bond issued by a foreign corporation or

govern-ment that is denominated in the investor’s home currency and sold in theinvestor’s home market A bond issued by a U.S company that is denominated inSwiss francs and sold in Switzerland is an example of a foreign bond Althoughthe foreign bond market is much smaller than the Eurobond market, many issuershave found this to be an attractive way of tapping debt markets in Germany,Japan, Switzerland, and the United States

Finally, the international equity market allows corporations to sell blocks of

shares to investors in a number of different countries simultaneously This ket enables corporations to raise far larger amounts of capital than they couldraise in any single national market International equity sales have also proven to

mar-be indispensable to governments that have sold state-owned companies to privateinvestors during recent years

The Role of Securities Exchanges

Securities exchanges create continuous liquid markets in which firms can obtain

needed financing They also create efficient markets that allocate funds to their

most productive uses This is especially true for securities that are actively traded

on major exchanges, where the competition among wealth-maximizing investorsdetermines and publicizes prices that are believed to be close to their true value.The price of an individual security is determined by the demand for andsupply of the security Figure 1.5 depicts the interaction of the forces of demand

(represented by line D0) and supply (represented by line S) for a given security currently selling at an equilibrium price P0 At that price, Q0shares of the stockare traded

Changing evaluations of a firm’s prospects cause changes in the demand forand supply of its securities and ultimately result in a new price for the securities

28 PART 1 Introduction to Managerial Finance

ordinary income

Income earned through the sale

of a firm’s goods or services.

LG6

Suppose, for example, that the firm shown in Figure 1.5 announces a favorablediscovery Investors expect rewarding results from the discovery, so they increasetheir valuations of the firm’s shares The changing evaluation results in a shift in

demand from D0to D1 At that new level of demand, Q1shares will be traded,

and a new, higher equilibrium price of P1will result The competitive market ated by the major securities exchanges provides a forum in which share price iscontinuously adjusted to changing demand and supply

cre-R e v i e w Q u e s t i o n s

1–18 Who are the key participants in the transactions of financial institutions?

Who are net suppliers and who are net demanders?

1–19 What role do financial markets play in our economy? What are primary

and secondary markets? What relationship exists between financial

insti-tutions and financial markets?

1–20 What is the money market? How does it work?

1–21 What is the Eurocurrency market? What is the London Interbank Offered

Rate (LIBOR) and how is it used in this market?

1–22 What is the capital market? What are the primary securities traded in it?

1–23 What role do securities exchanges play in the capital market? How does

the over-the-counter exchange operate? How does it differ from the

orga-nized securities exchanges?

1–24 Briefly describe the international capital markets, particularly the

Eurobond market and the international equity market.

1–25 What are efficient markets? What determines the price of an individual

security in such a market?

1.5 Business Taxes

Taxes are a fact of life, and businesses, like individuals, must pay taxes onincome The income of sole proprietorships and partnerships is taxed as theincome of the individual owners; corporate income is subject to corporate taxes.Regardless of their legal form, all businesses can earn two types of income: ordi-nary and capital gains Under current law, these two types of income are treateddifferently in the taxation of individuals; they are not treated differently for enti-ties subject to corporate taxes Frequent amendments in the tax code, such as the

Economic Growth and Tax Relief Reconciliation Act of 2001 (reflected in the

following discussions), make it likely that these rates will change before the next

edition of this text is published Emphasis here is given to corporate taxation.

Ordinary Income

The ordinary income of a corporation is income earned through the sale of goods

or services Ordinary income is currently taxed subject to the rates depicted in thecorporate tax rate schedule in Table 1.4

CHAPTER 1 The Role and Environment of Managerial Finance 29

average tax rate

A firm’s taxes divided by its

taxable income.

marginal tax rate

The rate at which additional

income is taxed.

T A B L E 1 4 Corporate Tax Rate Schedule

Tax calculation Range of taxable income Base tax  (Marginal rateamount over base bracket)

$ 0 to $ 50,000 $ 0  (15% amount over $ 0) 50,000 to 75,000 7,500  (25 amount over 50,000) 75,000 to 100,000 13,750  (34 amount over 75,000) 100,000 to 335,000a 22,250  (39 amount over 100,000) 335,000 to 10,000,000 113,900  (34 amount over 335,000) Over $10,000,000 3,400,000  (35 amount over 10,000,000)

aBecause corporations with taxable income in excess of $100,000 must increase their tax by the lesser of

$11,750 or 5% of the taxable income in excess of $100,000, they will end up paying a 39% tax on taxable income between $100,000 and $335,000 The 5% surtax that raises the tax rate from 34% to 39% causes all

corporations with taxable income between $335,000 and $10,000,000 to have an average tax rate of 34%.

E X A M P L E Webster Manufacturing, Inc., a small manufacturer of kitchen knives, has

before-tax earnings of $250,000 The before-tax on these earnings can be found by using thetax rate schedule in Table 1.4:

Total taxes due$22,250[0.39($250,000  $100,000)]

Average Versus Marginal Tax Rates

The average tax rate paid on the firm’s ordinary income can be calculated by

dividing its taxes by its taxable income For firms with taxable income of

$10,000,000 or less, the average tax rate ranges from 15 to 34 percent, reaching

34 percent when taxable income equals or exceeds $335,000 For firms withtaxable income in excess of $10,000,000, the average tax rate ranges between 34and 35 percent The average tax rate paid by Webster Manufacturing, Inc., in thepreceding example was 32.3 percent ($80,750$250,000) As a corporation’staxable income increases, its average tax rate approaches and finally reaches 34percent It remains at that level up to $10,000,000 of taxable income, beyondwhich it rises toward but never reaches 35 percent

The marginal tax rate represents the rate at which additional income is taxed.

In the current corporate tax structure, the marginal tax rate on income up to

$50,000 is 15 percent; from $50,000 to $75,000 it is 25 percent; and so on, asshown in Table 1.4 Webster Manufacturing’s marginal tax rate is currently 39percent because its next dollar of taxable income (bringing its before-tax earnings

to $250,001) would be taxed at that rate To simplify calculations in the text, a

fixed 40 percent tax rate is assumed to be applicable to ordinary corporate income Given our focus on financial decision making, this rate is assumed to rep-

resent the firm’s marginal tax rate.

30 PART 1 Introduction to Managerial Finance

double taxation

Occurs when the already

once-taxed earnings of a corporation

are distributed as cash dividends

to stockholders, who must pay

taxes on them.

intercorporate dividends

Dividends received by one

corporation on common and

preferred stock held in other

corporations.

8 The exclusion is 80% if the corporation owns between 20 and 80% of the stock in the corporation paying it dends; 100% of the dividends received are excluded if it owns more than 80% of the corporation paying it divi- dends For convenience, we are assuming here that the ownership interest in the dividend-paying corporation is less than 20%.

divi-Interest and Dividend Income

In the process of determining taxable income, any interest received by the

corpo-ration is included as ordinary income Dividends, on the other hand, are treated

differently This different treatment moderates the effect of double taxation,

which occurs when the already once-taxed earnings of a corporation are uted as cash dividends to stockholders, who must pay taxes on them Therefore,dividends that the firm receives on common and preferred stock held in other cor-porations, and representing less than 20 percent ownership in them, are subject

distrib-to a 70 percent exclusion for tax purposes.8

Because of the dividend exclusion, only 30 percent of these intercorporate

dividends are included as ordinary income The tax law provides this exclusion to

avoid triple taxation Triple taxation would occur if the first and second

corpora-tions were taxed on income before the second corporation paid dividends to itsshareholders, who must then include the dividends in their taxable incomes Thedividend exclusion in effect eliminates most of the potential tax liability from thedividends received by the second and any subsequent corporations

E X A M P L E Charnes Industries, a large foundry that makes custom castings for the

automo-bile industry, during the year just ended received $100,000 in interest on bonds itheld and $100,000 in dividends on common stock it owned in other corpora-tions The firm is subject to a 40% marginal tax rate and is eligible for a 70%exclusion on its intercorporate dividend receipts The after-tax income realized

by Charnes from each of these sources of investment income is found as follows:

As a result of the 70% dividend exclusion, the after-tax amount is greater for thedividend income than for the interest income Clearly, the dividend exclusionenhances the attractiveness of stock investments relative to bond investmentsmade by one corporation in another

Tax-Deductible Expenses

In calculating their taxes, corporations are allowed to deduct operating expenses,

as well as interest expense The tax deductibility of these expenses reduces theirafter-tax cost The following example illustrates the benefit of tax deductibility

Interest income Dividend income

(1) Before-tax amount $100,000 $100,000 Less: Applicable exclusion

0 (0.70$100,000)70,000 Taxable amount $100,000 $ 30,000 (2) Tax (40%)

40,000 12,000 After-tax amount [(1) (2)] $

60,000 $88,000

CHAPTER 1 The Role and Environment of Managerial Finance 31

capital gain

The amount by which the sale

price of an asset exceeds the

asset’s initial purchase price.

9 The Omnibus Budget Reconciliation Act of 1993 included a provision that allows the capital gains tax to be

halved on gains resulting from investments made after January 1, 1993, in startup firms with a value of less than $50 million that have been held for at least 5 years This special provision, which is intended to help startup firms, is ignored throughout this text.

E X A M P L E Two companies, Debt Co and No Debt Co., both expect in the coming year to

have earnings before interest and taxes of $200,000 Debt Co during the yearwill have to pay $30,000 in interest No Debt Co has no debt and therefore willhave no interest expense Calculation of the earnings after taxes for these twofirms is as follows:

Whereas Debt Co had $30,000 more interest expense than No Debt Co., DebtCo.’s earnings after taxes are only $18,000 less than those of No Debt Co.($102,000 for Debt Co versus $120,000 for No Debt Co.) This difference isattributable to the fact that Debt Co.’s $30,000 interest expense deduction pro-vided a tax savings of $12,000 ($68,000 for Debt Co versus $80,000 for NoDebt Co.) This amount can be calculated directly by multiplying the tax rate bythe amount of interest expense (0.40$30,000$12,000) Similarly, the

$18,000 after-tax cost of the interest expense can be calculated directly by

multi-plying one minus the tax rate by the amount of interest expense [(10.40)

$30,000$18,000]

The tax deductibility of certain expenses reduces their actual (after-tax) cost

to the profitable firm Note that both for accounting and tax purposes interest is

a tax-deductible expense, whereas dividends are not Because dividends are not

tax deductible, their after-tax cost is equal to the amount of the dividend Thus a

$30,000 cash dividend has an after-tax cost of $30,000

Capital Gains

If a firm sells a capital asset (such as stock held as an investment) for more thanits initial purchase price, the difference between the sale price and the purchase

price is called a capital gain For corporations, capital gains are added to ordinary

corporate income and taxed at the regular corporate rates, with a maximum ginal tax rate of 39 percent.9To simplify the computations presented in the text,

mar-as for ordinary income, a fixed 40 percent tax rate is mar-assumed to be applicable to

corporate capital gains.

Debt Co No Debt Co.

Earnings before interest and taxes $200,000 $200,000 Less: Interest expense

30,000 0 Earnings before taxes $170,000 $200,000 Less: Taxes (40%)

32 PART 1 Introduction to Managerial Finance

tax loss carryback/carryforward

A tax benefit that allows

corporations experiencing

operating losses to carry tax

losses back up to 2 years and

forward for as many as 20 years.

W WW

E X A M P L E Ross Company, a manufacturer of pharmaceuticals, has pretax operating

earn-ings of $500,000 and has just sold for $40,000 an asset that was purchased 2years ago for $36,000 Because the asset was sold for more than its initial pur-chase price, there is a capital gain of $4,000 ($40,000 sale price$36,000 initialpurchase price) The corporation’s taxable income will total $504,000 ($500,000ordinary income plus $4,000 capital gain) Because this total is above $335,000,the capital gain will be taxed at the 34% rate (see Table 1.4), resulting in a tax of

$1,360 (0.34$4,000)

Tax Loss Carrybacks and Carryforwards

Corporations that are experiencing operating losses may obtain tax relief by using a

tax loss carryback/carryforward The tax laws allow corporations to carry tax

losses back up to 2 years and forward for as many as 20 years This feature is

espe-cially attractive for firms in cyclic businesses such as durable goods manufacturingand construction It effectively allows them to average out their taxes over the goodand bad years The law requires the net amount of losses to first be carried back,applying them to the earliest year allowable, and progressively moving forwarduntil the loss has been fully recovered or the carryforward period has passed.Because tax losses can be carried back and applied to previous pretax earnings assoon as they are realized, the firm can apply for an immediate tax refund on its car-rybacks A carryforward, if any, can be used to reduce future income, therebyreducing future tax payments See the book’s Web site at www.aw.com/gitmanfor

an example of how tax loss carrybacks/carryforwards work

R e v i e w Q u e s t i o n s

1–26 Describe the tax treatment of ordinary income and that of capital gains What

is the difference between the average tax rate and the marginal tax rate?

1–27 Why might the intercorporate dividend exclusion make corporate stock

investments by one corporation in another more attractive than bondinvestments?

1–28 What benefit results from the tax deductibility of certain corporate

expenses?

1–29 How is the tax loss carryback/carryforward used when a firm experiences

an operating loss in a given year?

1.6 Using This Text

The organization of this textbook links the firm’s activities to its value, as mined in the securities markets The activities of the financial manager aredescribed in the six parts of the book Each major decision area is presented interms of both return and risk factors and their potential impact on owners’ wealth.Coverage of international events and topics is integrated into the chapter discus-sions, and a separate chapter on international managerial finance is also included.The text has been developed around a group of learning goals—six per chap-ter Mastery of these goals results in a broad understanding of managerialfinance These goals have been carefully integrated into a learning system Each

deter-CHAPTER 1 The Role and Environment of Managerial Finance 33

chapter begins with a numbered list of learning goals Next to each major textheading is a “toolbox,” which notes by number the specific learning goal(s)addressed in that section At the end of each section of the chapter (positionedbefore the next major heading) are review questions that test your understanding

of the material in that section At the end of each chapter, the chapter summaries,self-test problems, and problems are also keyed by number to each chapter’slearning goals By linking all elements to the learning goals, the integrated learn-ing system facilitates your mastery of the goals

Also keyed to various parts of the text is the PMF CD-ROM Software, a disk

for use with IBM PCs and compatible microcomputers The disk contains threedifferent sets of routines:

1 The PMF Tutor is a user-friendly program that extends self-testing

opportu-nities in the more quantitative chapters beyond those included in the chapter materials It gives immediate feedback with detailed solutions andprovides tutorial assistance (including text references) Text discussions and

end-of-end-of-chapter problems with which the PMF Tutor can be used are marked

with a

2 The PMF Problem-Solver can be used as an aid in performing many of the

routine financial calculations presented in the book A disk symbol, ,identifies those text discussions and end-of-chapter problems that can be

solved with the PMF Problem-Solver.

3 The PMF Excel Spreadsheet Templates can be used with Microsoft Excel to

input data and carry out “what-if” types of analyses in selected chapters.These problems are marked by the symbol .

A detailed discussion of how to use the PMF CD-ROM Software—the Tutor, the Problem-Solver, and the Excel Spreadsheet Templates—is included in

Appendix D at the back of this book

Each chapter ends with a case that integrates the chapter materials, and eachpart ends with an integrative case that ties together the key topical material cov-

ered in the chapters within that part Where applicable, the symbols for the PMF

Problem-Solver and/or the PMF Tutor identify case questions that can be solved

with the aid of these programs Both the chapter-end and the part-end cases can

be used to synthesize and apply related concepts and techniques

S U M M A RY

FOCUS ON VALUE

Chapter 1 established the primary goal of the firm—to maximize the wealth of the owners

for whom the firm is being operated For public companies, which are the focus of this text,

value at any time is reflected in the stock price Therefore, management should act only on

those alternatives or opportunities that are expected to create value for owners by increasing

the stock price Doing this requires management to consider the returns (magnitude and

tim-ing of cash flows) and the risk of each proposed action and their combined impact on value

34 PART 1 Introduction to Managerial Finance

REVIEW OF LEARNING GOALS

Define finance, the major areas of finance

and the career opportunities available in this

field and the legal forms of business organization.

Finance, the art and science of managing money,

affects the lives of every person and every

organiza-tion Major opportunities in financial services exist

within banking and related institutions, personal

financial planning, investments, real estate, and

in-surance Managerial finance is concerned with the

duties of the financial manager in the business firm

It offers numerous career opportunities, as shown in

Table 1.3 The recent trend toward globalization of

business activity has created new demands and

op-portunities in managerial finance

The legal forms of business organization are the

sole proprietorship, the partnership, and the

corpo-ration The corporation is dominant in terms of

business receipts and profits, and its owners are its

common and preferred stockholders Stockholders

expect to earn a return by receiving dividends or by

realizing gains through increases in share price The

key strengths and weaknesses of the common legal

forms of business organization are summarized in

Table 1.1 Other limited liability organizations are

listed and described in Table 1.2

Describe the managerial finance function and

its relationship to economics and accounting.

All areas of responsibility within a firm interact

with finance personnel and procedures In large

firms, the managerial finance function might be

handled by a separate department headed by the

vice president of finance (CFO), to whom the

trea-surer and controller report The financial manager

must understand the economic environment and

re-lies heavily on the economic principle of marginal

analysis to make financial decisions Financial

man-agers use accounting but concentrate on cash flows

and decision making

Identify the primary activities of the financial

manager within the firm The primary activities

of the financial manager, in addition to ongoing

in-volvement in financial analysis and planning, are

making investment decisions and making financing

decisions

Explain why wealth maximization, rather than

profit maximization, is the firm’s goal and how

LG4

LG3

LG2

fi-nancial manager is to maximize the owners’ wealth,

as evidenced by stock price Profit maximization nores the timing of returns, does not directly con-sider cash flows, and ignores risk, so it is an inap-propriate goal Both return and risk must beassessed by the financial manager who is evaluatingdecision alternatives The wealth-maximizing ac-tions of financial managers should also reflect theinterests of stakeholders, groups who have a directeconomic link to the firm Positive ethical practiceshelp the firm and its managers to achieve the firm’sgoal of owner wealth maximization

ig-An agency problem results when managers, asagents for owners, place personal goals ahead ofcorporate goals Market forces, in the firm of share-holder activism and the threat of takeover, tend toprevent or minimize agency problems Firms incuragency costs to monitor managers’ actions and pro-vide incentives for them to act in the best interests

of owners Stock options and performance plans areexamples of such agency costs

Understand the relationship between financial institutions and markets, and the role and operations of the money and capital markets.

Financial institutions serve as intermediaries bychanneling into loans or investments the savings ofindividuals, businesses, and governments Thefinancial markets are forums in which suppliers anddemanders of funds can transact business directly.Financial institutions actively participate in thefinancial markets as both suppliers and demanders

of funds

In the money market, marketable securities(short-term debt instruments) are traded, typicallythrough large New York banks and governmentsecurities dealers The Eurocurrency market is theinternational equivalent of the domestic moneymarket

In the capital market, transactions in long-termdebt (bonds) and equity (common and preferredstock) are made The organized securities exchangesprovide secondary markets for securities The over-the-counter exchange, a telecommunications net-work, offers a secondary market for securities and is

a primary market in which new public issues aresold Important debt and equity markets—theEurobond market and the international equity mar-

LG5

CHAPTER 1 The Role and Environment of Managerial Finance 35

LG6

LG4 LG2

LG1

ket—exist outside of the United States The

securi-ties exchanges create continuous liquid markets for

needed financing and allocate funds to their most

productive uses

Discuss the fundamentals of business taxation

of ordinary income and capital gains, and

ex-plain the treatment of tax losses Corporate income

is subject to corporate taxes Corporate tax rates

LG6

are applicable to both ordinary income (after tion of allowable expenses) and capital gains Theaverage tax rate paid by a corporation ranges from

deduc-15 to nearly 35 percent (For convenience, we sume a 40 percent marginal tax rate in this book.)Corporate taxpayers can reduce their taxes throughcertain provisions in the tax code: intercorporatedividend exclusions, tax-deductible expenses, andtax loss carrybacks and carryforwards

ST 1–1 Corporate taxes Montgomery Enterprises, Inc., had operating earnings of

$280,000 for the year just ended During the year the firm sold stock that it held

in another company for $180,000, which was $30,000 above its original chase price of $150,000, paid 1 year earlier

pur-a What is the amount, if any, of capital gains realized during the year?

b How much total taxable income did the firm earn during the year?

c Use the corporate tax rate schedule given in Table 1.4 to calculate the firm’s

total taxes due

d Calculate both the average tax rate and the marginal tax rate on the basis of

your findings

PROBLEMS

1–1 Liability comparisons Merideth Harper has invested $25,000 in Southwest

Development Company The firm has recently declared bankruptcy and has

$60,000 in unpaid debts Explain the nature of payments, if any, by Ms Harper

in each of the following situations

a Southwest Development Company is a sole proprietorship owned by Ms.

Harper

b Southwest Development Company is a 50–50 partnership of Ms Harper and

Christopher Black

c Southwest Development Company is a corporation.

1–2 Marginal analysis and the goal of the firm Ken Allen, capital budgeting analyst

for Bally Gears, Inc., has been asked to evaluate a proposal The manager of theautomotive division believes that replacing the robotics used on the heavy truckgear line will produce total benefits of $560,000 (in today’s dollars) over thenext 5 years The existing robotics would produce benefits of $400,000 (also intoday’s dollars) over that same time period An initial cash investment of

$220,000 would be required to install the new equipment The manager mates that the existing robotics can be sold for $70,000 Show how Ken willapply marginal analysis techniques to determine the following:

esti-a The marginal (added) benefits of the proposed new robotics.

b The marginal (added) cost of the proposed new robotics.

c The net benefit of the proposed new robotics.

d What should Ken Allen recommend that the company do? Why?

e What factors besides the costs and benefits should be considered before the

final decision is made?

36 PART 1 Introduction to Managerial Finance

LG4

LG6

LG6

LG6

LG2 1–3 Accrual income versus cash flow for a period Thomas Book Sales, Inc.,

sup-plies textbooks to college and university bookstores The books are shipped with

a proviso that they must be paid for within 30 days but can be returned for a fullrefund credit within 90 days In 2003, Thomas shipped and billed book titlestotaling $760,000 Collections, net of return credits, during the year totaled

$690,000 The company spent $300,000 acquiring the books that it shipped

a Using accrual accounting and the preceding values, show the firm’s net profit

for the past year

b Using cash accounting and the preceding values, show the firm’s net cash

flow for the past year

c Which of these statements is more useful to the financial manager? Why? 1–4 Identifying agency problems, costs, and resolutions Explain why each of the

following situations is an agency problem and what costs to the firm mightresult from it Suggest how the problem might be dealt with short of firing theindividual(s) involved

a The front desk receptionist routinely takes an extra 20 minutes of lunch to

run personal errands

b Division managers are padding cost estimates in order to show short-term

efficiency gains when the costs come in lower than the estimates

c The firm’s chief executive officer has secret talks with a competitor about the

possibility of a merger in which (s)he would become the CEO of the bined firms

com-d A branch manager lays off experienced full-time employees and staffs

cus-tomer service positions with part-time or temporary workers to loweremployment costs and raise this year’s branch profit The manager’s bonus isbased on profitability

1–5 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the

exclu-sive distributor of a major line of sporting goods During 2003 the firm earned

$92,500 before taxes

a Calculate the firm’s tax liability using the corporate tax rate schedule given in

Table 1.4

b How much are Tantor Supply’s 2003 after-tax earnings?

c What was the firm’s average tax rate, based on your findings in part a?

d What is the firm’s marginal tax rate, based on your findings in part a?

1–6 Average corporate tax rates Using the corporate tax rate schedule given in

Table 1.4, perform the following:

a Calculate the tax liability, after-tax earnings, and average tax rates for the

following levels of corporate earnings before taxes: $10,000; $80,000;

$300,000; $500,000; $1.5 million; $10 million; and $15 million

b Plot the average tax rates (measured on the y axis) against the pretax income

levels (measured on the x axis) What generalization can be made concerning

the relationship between these variables?

1–7 Marginal corporate tax rates Using the corporate tax rate schedule given in

Table 1.4, perform the following:

a Find the marginal tax rate for the following levels of corporate earnings

before taxes: $15,000; $60,000; $90,000; $200,000; $400,000; $1 million;and $20 million

CHAPTER 1 The Role and Environment of Managerial Finance 37

LG6

LG6

LG6

LG6

b Plot the marginal tax rates (measured on the y axis) against the pretax

income levels (measured on the x axis) Explain the relationship between

these variables

1–8 Interest versus dividend income During the year just ended, Shering

Distributors, Inc., had pretax earnings from operations of $490,000 In tion, during the year it received $20,000 in income from interest on bonds itheld in Zig Manufacturing and received $20,000 in income from dividends onits 5% common stock holding in Tank Industries, Inc Shering is in the 40% tax bracket and is eligible for a 70% dividend exclusion on its Tank Industriesstock

addi-a Calculate the firm’s tax on its operating earnings only.

b Find the tax and the after-tax amount attributable to the interest income

from Zig Manufacturing bonds

c Find the tax and the after-tax amount attributable to the dividend income

from the Tank Industries, Inc., common stock

d Compare, contrast, and discuss the after-tax amounts resulting from the

interest income and dividend income calculated in parts b and c.

e What is the firm’s total tax liability for the year?

1–9 Interest versus dividend expense Michaels Corporation expects earnings before

interest and taxes to be $40,000 for this period Assuming an ordinary tax rate

of 40%, compute the firm’s earnings after taxes and earnings available for mon stockholders (earnings after taxes and preferred stock dividends, if any)under the following conditions:

com-a The firm pays $10,000 in interest.

b The firm pays $10,000 in preferred stock dividends.

1–10 Capital gains taxes Perkins Manufacturing is considering the sale of two

non-depreciable assets, X and Y Asset X was purchased for $2,000 and will be soldtoday for $2,250 Asset Y was purchased for $30,000 and will be sold today for

$35,000 The firm is subject to a 40% tax rate on capital gains

a Calculate the amount of capital gain, if any, realized on each of the assets.

b Calculate the tax on the sale of each asset.

1–11 Capital gains taxes The following table contains purchase and sale prices for

the nondepreciable capital assets of a major corporation The firm paid taxes of40% on capital gains

a Determine the amount of capital gain realized on each of the five assets.

b Calculate the amount of tax paid on each of the assets.

Asset Purchase price Sale price

38 PART 1 Introduction to Managerial Finance

W WW

CHAPTER 1 CASE Assessing the Goal of Sports Products, Inc.

Loren Seguara and Dale Johnson both work for Sports Products, Inc., a majorproducer of boating equipment and accessories Loren works as a clericalassistant in the Accounting Department, and Dale works as a packager in theShipping Department During their lunch break one day, they began talkingabout the company Dale complained that he had always worked hard trying not

to waste packing materials and efficiently and cost-effectively performing hisjob In spite of his efforts and those of his co-workers in the department, thefirm’s stock price had declined nearly $2 per share over the past 9 months.Loren indicated that she shared Dale’s frustration, particularly because the firm’sprofits had been rising Neither could understand why the firm’s stock price wasfalling as profits rose

Loren indicated that she had seen documents describing the firm’s sharing plan under which all managers were partially compensated on the basis

profit-of the firm’s prprofit-ofits She suggested that maybe it was prprofit-ofit that was important

to management, because it directly affected their pay Dale said, “That doesn’tmake sense, because the stockholders own the firm Shouldn’t management dowhat’s best for stockholders? Something’s wrong!” Loren responded, “Well,maybe that explains why the company hasn’t concerned itself with the stockprice Look, the only profits that stockholders receive are in the form of cashdividends, and this firm has never paid dividends during its 20-year history We

as stockholders therefore don’t directly benefit from profits The only way webenefit is for the stock price to rise.” Dale chimed in, “That probably explainswhy the firm is being sued by state and federal environmental officials for dump-ing pollutants in the adjacent stream Why spend money for pollution control? Itincreases costs, lowers profits, and therefore lowers management’s earnings!”Loren and Dale realized that the lunch break had ended and they mustquickly return to work Before leaving, they decided to meet the next day to con-tinue their discussion

Required

a What should the management of Sports Products, Inc., pursue as its

overrid-ing goal? Why?

b Does the firm appear to have an agency problem? Explain.

c Evaluate the firm’s approach to pollution control Does it seem to be ethical?

Why might incurring the expense to control pollution be in the best interests

of the firm’s owners in spite of its negative impact on profits?

d On the basis of the information provided, what specific recommendations

would you offer the firm?

WEB EXERCISE At the Careers in Finance Web site, www.careers-in-finance.com, you will find

information on career opportunities in seven different areas of finance First

click on Corporate Finance in the Areas to Explore section and use the various

subsections to answer the following questions:

1 What are the primary responsibilities of the financial manager?

2 Summarize the types of skills a financial manager needs.

CHAPTER 1 The Role and Environment of Managerial Finance 39

Remember to check the book’s Web site at

www.aw.com/gitman for additional resources, including additional Web exercises.

3 Describe the key job areas in corporate finance.

4 What are the salary ranges for the following positions in corporate finance:

rookie financial analyst, credit manager, chief financial officer? How dothese compare to salaries at General Motors or PepsiCo?

Now return to the home page and click on either Commercial Banking or

Invest-ment Banking.

5 How do careers in the area you chose (commercial banking or investment

banking) compare to careers in corporate finance in terms of skills required,responsibilities, and salaries?